The U.S. Economy in 2013:
Implications for State Revenue Volatility

By Rick Mattoon

After economic growth proved slower than anticipated in 2012, the key question most economists have been asking is this: Will growth in 2013 accelerate to a point that the U.S. will begin to make a meaningful dent in unemployment and close other gaps in the economy that emerged after the so-called Great Recession? Most economists expect a stronger level of growth in 2013, but few are calling for real gross domestic product growth of more than 2.5 percent to 3 percent. While this level of growth would certainly help, it would still continue the trend of the economy only slowly returning to pre-recession growth levels. For states, this will likely lead to revenue growth that will be moderate at best.

What Parts Of The Economy Will Do Well?

Manufacturing and agriculture have led the way during the current recovery. A resurgent auto industry and growth in demand for construction and capital equipment kept factories busy and supply chains humming. In the farm belt, high prices for corn and soybeans, as well as livestock, pushed up farm incomes. Farmland values have continued to soar partially in response to these gains. Even in light of last year’s devastating drought, farm incomes have been largely protected through crop insurance.

During this time, other sectors of the economy that usually are robust participants in recoveries largely stayed on the sidelines. In particular, real estate—suffering from a glut of supply, foreclosures and financial issues—continued to drag the economy. By the fall of 2012, however, some evidence indicated real estate may have bottomed out and was turning the corner, with limited evidence that prices are actually turning up. If this continues in 2013, it will significantly add to growth prospects.

What Keeps Economists Up At Night?

The threats to better growth in 2013 are significant. A slowdown in Asia’s economies, particularly in China, will dampen demand for many heavy manufacturing products. Continued turmoil in the Eurozone will find negligible growth in European markets. Even if the federal government avoids a fiscal cliff, the continued impact of high federal deficits and likely spending reductions will crimp growth. Local governments continue to feel the impact of declining property values straining local property tax bases.

What Will This Mean For State Revenues?

Some recent work that I have done with colleague Leslie McGranahan found that state revenues have become more volatile in responding to national economic cycles since about 2000. Specifically, personal income tax revenues are more than twice as volatile as they were in earlier periods due primarily to changes in personal income dynamics .

As nonwage, investment income has grown in importance, personal income tax receipts have tended to exhibit greater boom and busts and are far less predictable. Some of this has been amplified by tax policy choices that often have given favorable treatment to investment income, but most can be accounted for by a higher share of income being derived from investments and other forms of capital gains related income.

The issue for states is that it often is up to the individual taxpayer when they choose to recognize these types of income. For example, if investment income is subject to higher tax rates in 2013, it might lead to a rush to recognize investment income in 2012 to avoid the rate increase. Similarly changes in federal tax policy might impact other forms of tax preferences, such as mortgage deductibility, that in turn might change taxpayer behavior.

In Summation …

If some of the headwinds—poor real estate performance, sluggish consumer spending—that have characterized the slow nature of the current recovery can turn into tailwinds, the economy may see a lift in 2013 relative to 2012. However, few predict a sharp upward turn; most believe it will be a gradual acceleration that has legs into future years.

ABOUT THE AUTHOR

Rick Mattoon is a senior economist and economic adviser in the economic research department of the Federal Reserve Bank of Chicago. Mattoon's primary research focuses on issues that face the Midwest regional economy. Mattoon began his career at the Chicago Fed in 1990. He left the bank in 1997, but returned in 2001.